Chapter 03 Principles of Insurance
Insurance Quotient Boosters
The insurance business is governed by certain guiding principles. The following are the principles of insurance:
- Insurable Interest
- Utmost Good Faith or Uberrima Fides
- Indemnity
- Subrogation
- Contribution
- Proximate Cause
- Principle of Loss Minimization
Insurable Interest
The person getting an insurance policy must have an insurable interest in the property or life insured.
The presence of insurable interest is a legal requirement. So an insurance contract without the existence of insurable interest is not legally valid and cannot be claimed in a Court.
The intent behind this principle is that the insured must be in a position to financially suffer if a loss occurs. This principle helps in preventing gambling by way of taking insurance on a property and waiting for a loss to occur. In case of life insurance contracts, it reduces moral hazard whereby a person takes life insurance on another person and prays for his/ her death for insurance claims.
Let’s consider this example.
If your house is damaged by fire, you suffer a financial loss resulting from the fire. By contrast, if your neighbour’s house, which you do not own, is damaged by fire, you may feel sympathy for your neighbour but you have not suffered a financial loss from the fire. Hence, you have an insurable interest in your own house, but not in your neighbour’s house.
Utmost Good Faith or Uberrima Fides
The principle of Utmost Good Faith or Uberrima Fides is the primary principle of insurance. An insurance contract is a contract of utmost good faith.
Something is material if it would influence an insurer in determining whether to cover the risk, and if so, upon what terms.
All material information must be disclosed to both the parties to the contract i.e. Insured and Insurer. Since the insurance concept is based on the probability of a loss occurring, complete disclosure of the risk to be insured is of paramount importance in assessing the quality of risk and pricing of premium.
Let’s understand this with the help of an example.
John took a Health Insurance policy. He was a smoker and he did not disclose this fact at the time of taking the policy. Later in life, he was diagnosed with cancer, which could have been a cause of his smoking. The insurance company would not pay the claim as John did not reveal an important fact (his habit of smoking) before purchasing the insurance policy.
Principle of Indemnity
Insurance aims at helping the insured to recover from a financial blow by reducing the financial impact of a calamity.
He neither profits nor is disadvantaged by the loss.
The principle of indemnity is applicable to all types of insurance policies except life insurance. Indemnity means security, protection and compensation given against damage, loss or injury. The insurer promises to help the insured in restoring the financial position they were in before the loss occurred. Whenever there is a loss of property, the loss is compensated. The compensation payable and the loss suffered should be measurable in terms of money. The insured will be compensated only up to the amount of loss suffered by him.
All insurance policies mention the sum insured which represents the maximum liability under the contract. Depending upon the type of insurance policy, the sum insured represents:
- The value of a car
- The value of a house
- The estimated medical expenditure
- The amount that would take care of a family’s financial needs in case of the breadwinner’s death
Let’s take the example of Jayesh.
Jayesh’s shop caught fire and as a result, a part of the goods that were stored inside was destroyed. The shop was insured for its full value of Rs. 5,00,000. Jayesh claimed Rs. 5,00,000 since he had insured his shop for Rs. 5,00,000. The insurance company’s surveyor examined the damage and estimated that the loss was only Rs. 64,000. The insurance company paid Rs. 64,000 as compensation, even though Jayesh had a policy of Rs. 5,00,000 and claimed for more. Here the insurance company has applied the “principle of indemnity”. Since only part of the goods were destroyed, only a part of the sum insured is paid as compensation under the policy. You get compensated for what you lose - no more, no less.
Subrogation
In many cases, the insured is not directly the cause of the loss. The loss has been caused by a certain third party.
When you file a claim with the insurance company and another driver or party is at fault, the insurance company will generally:
- Pay the claim in order to indemnify you (cover your damages and injuries)
- Seek to recover the money they paid - or at least a part of it - from the parties that are at fault in the accident
According to the principle of subrogation, when the insured is compensated for the losses due to damage to his insured property, then the ownership right of such property shifts to the insurer. The insurer's right of subrogation arises only when the insurer has paid for the loss. If the insured party gets a compensation for the loss suffered by him, he cannot claim the same amount of loss from any other party. It prevents the insured being indemnified from two sources in respect of the same loss.
Let’s simplify this with an example.
On his transfer from Kolkata to Mumbai, Rajan sent his household goods worth Rs. 1,00,000 through Jayant Transports. During the transit, part of the goods got damaged due to the truck driver’s negligence. The insurer assessed the loss and found that the value of the damage was Rs. 30,000 and paid this amount to Rajan as indemnity.
However, Rajan took up the matter against Jayant Transports with the Court of Law and the Court ordered Jayant Transports to pay Rs. 30,000 to Rajan. Having already received Rs. 30,000 from the insurer, Rajan would be making a profit out of the loss if he gets Rs. 30,000 from the transporter also.
From this situation, one should observe the following:
- The insurance company has to compensate Rajan, as per the insurance contract at the earliest without making him wait for the Court’s judgement.
- Rajan should not get two compensations and make a profit out of his loss. In such situations, the insured’s right to claim from anywhere else is taken over by the insurer when he pays a claim. This taking over of the insured’s right by the insurer is called ‘subrogation’ in insurance language. In other words, on payment of the claim, the insured’s right to claim from anywhere else gets ‘subrogated’ to the insurer.
Contribution
Sometimes a property is insured with more than one company. The insured cannot claim more than the total loss from all the insurance companies put together. He cannot claim the same loss from different insurance companies. If one insurer pays full compensation, then that insurer can claim proportionate claim from the other insurers. A person cannot be restored to a better position than before the loss occurred.
Let’s take a look at an example.
Kishore had a car worth Rs. 5,00,000 and he took full insurance for this car from two insurance companies. The car was totally damaged in an accident and the total loss was Rs. 5,00,000. Kishore filed a claim with the 1st company and got paid Rs. 5,00,000.
He goes to the 2nd insurance company and makes a claim for Rs. 5,00,000. The second company informed Kishore that he was not eligible for getting anymore claim because he was already indemnified by the 1st Company. If the 2nd company had also paid him, he would have made a profit out of his loss, which is against the principle of indemnity.
As per the principle of contribution, the 1st insurance company can recover proportionate claim from the 2nd insurer who is also liable for the loss.
Principle of Proximate Cause
A loss may not be caused by just one cause, it could also be a chain of events that lead to the actual loss.
This principle is found very useful when the loss occurs due to a series of events. The principle states that to find out whether the insurer is liable for the loss or not, the proximate (closest) and not the remote (farthest) must be looked into.
However, in case of life insurance, the principle of Proximate Cause does not apply. Whatever may be the reason of death, the insurer is liable to pay the amount of insurance.
Under this rule, to determine whether a loss has resulted from a cause covered under an insurance policy, a court looks for the predominant cause which sets into motion the chain of events producing the loss, which may not necessarily be the last event that immediately preceded the loss.
To understand this better, let’s consider this example.
Prathamesh had taken an accident insurance policy which covered death by accident. While walking on the road one day, he was hit by a car and was rushed to the hospital. Being a person with a weak heart, he could not stand the shock of the event and died after a few hours from heart failure. The insurance company disputed the claim saying it was the heart attack rather than the accident which had caused his death. The court ruled that even though the immediate cause of death may have been the collapse of the heart, the proximate cause of death was the accident and ordered the company to pay the claim.
Principle of Loss Minimization
Insurance companies must protect themselves against unjustified claims. In certain cases, the insured encourages the loss of assets in order to claim a higher amount from the insurance company. This is unethical.
The insured must take all necessary steps to control and reduce the losses and to save what is left. This principle makes the insured more careful with respect to this insured property, just as any sensible person would do in those situations. If he does not do so, the insurer can avoid the payment of loss attributable to his negligence. But it must be remembered that though the insured is bound to do his best for his insurer, he is not bound to do so at the risk of his life.
The insured must not neglect and behave irresponsibly during such events just because the property is insured. Hence, it is the responsibility of the insured to protect his insured property and avoid further losses.
Let’s take an example to understand this principle.
John's house catches fire due to an electric short-circuit. In this tragic scenario, John must try his level best to stop the fire by all possible means, like first calling the nearest fire department office, asking neighbours for emergency fire extinguishers, etc. He must not remain inactive and watch his house burning with the thought, "Why should I worry? I've insured my house."
These principles guide the activities of the insured and the insurer to ensure that neither of the parties is at a disadvantage.
